Exchange Risk - Research Paper Example

Table of Contents Table of Contents 1 Executive Summary 2 Introduction 3 Exchange Rate Risk 5 Dealing with Exchange rate risk 8 Hedging Payable amount of Exports 9 Forward Market Hedge 9 Money Market Hedge 9 Options Market Hedge 10 Political risk 11 Recommendations 13 Hedging the Exports 13 Conclusion 13 Bibliography 15 Exhibits 16 Executive Summary The exchange rate risk is the most important among these various forms of risk. In earlier times trading occurred by exchanging goods for precious metals. The reason for these different payment methods for trading was the lack of an international currency valuating or trading system. To avoid this discrepancy some kingdom printed currency on gold and silver. This was an effective method of valuing currency and easing problems of international trade. Antartico private limited is a hypothetical company which is based in United States and conducts business with United Kingdom. The home currency of Antartico Private Limited is United States Dollars, however bulk of its revenues are based in United States dollars. Therefore currency is constantly exposed to exchange rate risk. This directly affects the value of Antartico Private Limited as a whole because all investors calculate present value of future expected cash flows to asses a firm’s value. Antartico Private Limited has very limited options when it comes to changing its target market to avoid this risk. Antartico Private Limited manufactures and brands football equipment. Antartico Private Limited as mentioned exports goods from United States to United Kingdom. Michigan State agreed to the terms and deposited a sum of 25,000 GBP into Antartico Private Limited accounts, which was fifty percent of total price. There are many different options for Antartico for hedging its exchange rate risk. Each strategy however has different costs and benefits. Introduction There are many different risks associated with doing business in the new global scenario. The risks associated with international trade are even more unpredictable and expensive. These risks include political, default, legal, Exchange rate risk etc (Eun &Resnick, 2004). The exchange rate risk is the most important among these various forms of risk. This is because all the other risks are translated ultimately into exchange rate risk in international transactions. The world has evolved over the last few decades. International trade however is not a new concept to human civilizations. The methods of payment however have been totally changed by recent revolutions in financial systems. In those times most of the trade occurred on a barter system. The barter system basically means that a commodity is exchanged for another commodity. The prices in the barter system are set almost the same way as in normal transactions. The difference however lies in the fact that instead of supply/demand relationship of a commodity and demand/supply relationship between two commodities was established. Thus the quantities for two different products established. Trading however also occurred by exchanging goods for precious metals (Eun &Resnick, 2004). The gold was primarily used as the main metal for trading. The reason for these different payment methods for trading was the lack of an international currency valuating or trading system. The countries could not trust each other when it came to valuation of currencies as there was no way to calculates externally factors which determine the value of a currency. To avoid this discrepancy some kingdom printed currency on gold and silver. This was an effective method of valuing currency and easing problems of international trade. With the introduction of international financial consolidation, effective exchanges were set up for valuation and exchange of currency. The gold standard system was replaced by a fixed exchange rate system. Under this system value of all currencies was fixed against a currency. National currencies under this system were monitored very closely and it was ensured that there were no sudden movements in value of any currency. The 1970s however saw a sudden overvaluation of dollar which had disastrous effects for currencies pegged against the dollar. The fixed exchange rate system was thus abolished. The need arose for a new system which could incorporate the effects of inflation in exchange value of currencies. Thus the floating exchange rate system was implemented internationally. This system is practiced until today internationally. The economic practicality of the exchange rate system is the main reason behind its success. According to the floating exchange rate system the supply and demand for each currency is determined by market forces and thus a price is automatically established. Antartico Private Limited Antartico private limited is a hypothetical company which is based in United States and conducts business with United Kingdom. The revenue currency of Antartico Private Limited is Great British Pound, however bulk of its costs are based in United States dollars. Therefore currency is constantly exposed to exchange rate risk. This high level of risk has made it very difficult for Antartico Private Limited to raise debt capital. This is because all cash flow of Antartico Private Limited have a high level of risk associated, thus the value of its cash flows is greatly reduced. This directly affects the value of Antartico Private Limited as a whole because all investors calculate present value of future expected cash flows to asses a firm’s value. Antartico Private Limited has very limited options when it comes to changing its target market to avoid this risk. Antartico Private Limited manufactures and brands football equipment. They have multiple contracts with many minor and major clubs based in all around United Kingdom. The company has some smaller contracts with universities and colleges for manufacturing of custom made football equipment and kits. The payments for Antartico Private Limited’s equipment are made in two parts. At the contract signing, fifty percent of total payment is made in advance. The rest is made on delivery of goods. Thus all the costs of Antartico Private Limited are in United States Dollars while the revenues are in Great British Pounds. Exchange Rate Risk The currency market unlike the stock exchange of the world is not a physical market where currency is traded. Instead it’s a global network of different banks and financial institutions connected through wide and efficient communication networks. The most common currency market is the spot market for currency. In this market exchanges rates are established and review on a day to day basis. A currency for any other currency can be exchanged for a given rate (this given rate is established according to supply and demand for a currency as explained above in floating exchange system). The size of the world spot market is currently over 1.5 trillion USD (Madura, 2007). The international sport market operates under a strict equilibrium. The efficient communication networks are the key behind this efficiency of spot markets. This communication system allows banks and other trading entities to monitor international prices and movements of currency. If for example an investor is trading British Pound for American dollars, he would first analyze the international prices at which dollar is being bought and bargain accordingly. Exchange rate movements There are many different factors which contribute to the movement of international currencies. The behavioral factors are almost impossible to predict thus it becomes very difficult to predict exchange rate fluctuations. As discussed above supply and demand forces are critical to Exchange rates (Eun &Resnick, 2004). The following factors affect these supply and demand forces and thus exchange rates: Inflations rates International trade activity is partially dependent on the inflation rates, prevailing in trading countries. When inflation increases, the price of goods in a country increases as well (Brigham, 2007). Relative interest rates Interest rates are the key factor in determining the investments in foreign subsidiaries (Madura, 2007). Variation in these investments affects the demand for a currency, consequently affecting exchange rates. Income Income levels have a huge impact on the demand of any currency. If income levels are high means consumers can pay more to buy imported goods. Government Interventions Governments follow different monetary policies according to their own economic and fiscal goals. The can use the following key measures applied by the government (Madura, 2007): 1) imposing foreign Exchange barriers 2) imposing foreign trade barriers 3) intervening by buying and selling currencies in the foreign markets 4) affecting inflation 5) interest rates policies Market Sentiments Expectations from future performance of a currency, is the single most dominant factor when it comes down to, day to day variations in Exchange rates. This is a field of behavioral finance and is the most difficult aspect to predict when predicting currency fluctuations. Dealing with Exchange rate risk Antartico Private Limited as mentioned exports goods from United States to United Kingdom. On June 10, 2010 an order was placed by Manchester University for manufacturing of both kits and football equipment. The kits were to be custom made according to requirements of Manchester University. Therefore Antartico Private Limited asked for a manufacturing period of 3 months. Manchester University agreed to the terms and deposited a sum of 25,000 GBP into Antartico Private Limited accounts. However in terms of dollars this amounted to 36,880 USD. The remaining 25,000 GBP was to be paid at a later date to Antartico Private Limited. The contract was signed in terms of Great British Pounds. Antartico Private Limited insisted at the contract signing that it should be signed in terms of United States Dollars. The reason behind insistence of Antartico Private Limited was to safeguard them against any depreciation dollar. The ailing British economy was a general concern for Antartico Private Limited and therefore to reduce their exchange risk a strategy had to be formulated. The company has the following options in hedging: Options Market Forward Contract Money Market Antartico Private Limited will have to analyze which hedging strategy would cost them the lowest. Hedging Payable amount of Exports Forward Market Hedge On the time of contract i.e. June 10 2010 the rate of one GBP in terms of USD was 1.45571. The three month forward rate at the same time was 1.4663 (FXpro, 2010). In order for Antartico Private Limited to enter into the forward market they will have to enter into a short position for Great British Pound. This would mean that they would make a contract of selling 25,000 Great British Pound in three months from now.   Rate Amount of GBP Total USD Spot 1.45571 25000 36392.75 Forward 1.4663 25000 36657.5 If the company used forward contact we can see that the price received would be higher as compared to price of GBP received today. This is because GBP is expected to increase in value in the near future. Money Market Hedge The 3 month interest rate in United Kingdom is 0.27% (Yieldcurve, 2010). The 3 month interest rate in the Unites States is however 0.12% (Yieldcurve, 2010). If Antartico Private Limited is to engage in money market hedge it will have to borrow money in United Kingdom convert it into United Sates Dollars and invest that money into an American Bank. The following transactions would occur. 1- 25,000 Pounds are borrowed by Antartico Private Limited 2- Antartico converts these 25,000 Pounds into United States Dollars 25000 GBP = 36,392 USD 3- Antartico invests this 36,392 in a three month deposit in US 36,392 (1 + 0.0012) = 36436.26 4- The company will receive 25,000 pounds after 3 months and pay back the bank with the following interest addition 25000 (1 + 0.0027) = 25067 An amount of 67 pounds will be charged as interest by the UK bank. The bank in US will pay a sum of 44 dollars for deposits. Using 3 month forward rate Antartico will earn $44 dollars in interest and pay $98 (67x 1.46). Options Market Hedge Antartico can also engage in an option strategy to hedge its exchange rate risk. To hedge its risk Antartico Private Limited will have to buy a put option in America. This would enable them to sell GBP at a given price if need occurs i.e. value of GBP depreciates against dollar. According to (OZforex, 2010) an option with a strike price of 1.5 GBP will cost 441 USD pounds for call option on 25000 GBP. This would hedge them against any risk from falling value of GBP. The following will be the cost of this transaction: 25000 (1.5-1.45) = 1107 However if the options is not exercised the entire sum of 441 dollars will be lost and considered sunk costs. Political risk Great Britain Pound The British economy is a quite strong pillar amongst the world economies with a ranking coming in on 3rd largest in the world. With a strong investment oriented background, it has been the leading nation in the modern world industrialization and creation of modern multinationals. Unlike the U.S, its economy has not relied on agricultural produce due to lack of such land. The economy itself has to maintain a balance which for Britain, is done mainly through foreign investments. With total exports amounting to around 442.2 billion dollars of which main items include electronics, textiles and machinery, and imports ranging over 662 billion dollars, it maintains a staggering 200 billion dollars trade deficit. This financial burden is mainly offset by tourism, foreign investments and the large number of foreign student population. The British government, having an invested stake in its many corporations, provides significant support to them. This vested interest became significant when the corporations were in need of support in the financial crisis of the world recently with the economy shrinking nearly 5.9% in 2008. The lending structure added to the meltdown as British banks were similar in nature to the U.S which means that they allowed large personal landings to industries and individuals with credit rating (as well as the real estate industry). When this structure and practice failed, so did the economy which affected all sectors eventually. The once economic leader, now, with an economy shrinking rate of .4% in 2009, Britain has fallen behind its European counterparts who have shown signs of recovery. The British Central Bank used a floating rate scheme even in the times of the economic meltdown as this system is closely related to the U.S system of banking. This Translates into the fact that the U.S. and British currencies are closely related and can suffer similar fluctuations due to their shared economical and political structures. The European Union, having inducted Britain as a member had pressed Britain to change the currency from Pound to Euro to which the reply was a refusal. This rejection is said to originate mainly from the historical aspects of the Pound where centuries ago, it dictated the fates of many nations. Thus, the great British Pound is more of a legacy then simply a currency. United States Dollar The forerunner and promoter of free market economy and with a currency of U.S Dollar (USD), the U.S economy is the titan of all economies of the world with an astounding per capita GDP of $47,422. The free market economy has given the power to the private corporations for making the production and supply decisions studying the demand in the market. This is followed by the fact that U.S is the major importer of foreign goods (National Economic accounts, 2009) which makes several economies dependent on its demand structures. This economy however, has its own share of troubles resulting from the financial crisis of the world including low investor trust, fall of demand of goods as well as rise of unemployment. Oil, the major import of the U.S is has always had a significant effect of its economic signs. The USD is by far the most influential currency in the world where countries literally peg their currency to the USD like a 1:1 ratio adoption by Panama. The greatest hit to the USD has been perhaps the potential switching of countries to keep their foreign reserves in an alternative currency like the Euro (instead of the USD) against which the USD has been depreciating gradually due to factors which effect its price like market demand and supply, interest rates etc. The U.S Federal Reserve Bank has made attempts to reduce this effect by lowering the interest rates to increase the demand for dollars but the results aren’t encouraging due to the weak economy of the U.S. China, which is considered a huge trade partner to the U.S, had announced in 2009 to transfigure its $1.9 trillion reserves into Euros (Frankel, 2009) which is a significant event for the USD future. One noteworthy factor to be seen is the appreciating U.S currency despite the trade deficit which is due to the large investments in the U.S reducing the harmful effect of the deficit. Thus, the USD still has a long way to go. Recommendations Hedging the Exports Three different strategies have been discussed above which effectively hedge Exchange rate risk for Antartico. However to choose the most appropriate we will have to conduct an analysis of their cost to the company. Hedging in the money market will cost Antartico the interest rate differentials. As has been shown the interest amount paid for borrowed funds is higher than interest received for deposit of funds. The option strategy for hedging is very expensive. The high premium paid on the option makes this strategy risky. The best option for Antartico is to engage in a forward market hedge. As has been shown with calculation it’s the only safe, low cost and profitable strategy. Conclusion Three different methods of hedging have been calculated for Antartico. The assumption behind all these calculations is the lack of transactions cost. It also assumes that there will a supply of options available and counter-parties would enter into forward contracts. This however is not true in the real world. There are many different unforeseen circumstances that must be taken into account. In most hedging attempts the transactions costs are usually the highest. The money market option however has the least transaction cost as compared to other strategies. This is because all transaction costs are usually included in the cost of borrowing by banks. Moreover there are no complex procedures involving derivative finance. Using derivates to hedge would require Antartico Private Limited to operate a separate department for hedging which would increase its administrative cost. The company should therefore indulge in money market hedges as they require the least amount of financial expertise. This strategy has been proven successful in the workings shown. Moreover it would enable a successful and realistic strategy for a small company like Antartico Private Limited. Bibliography 1. Eun, C. Resnick, B. ,2004. International Financial Management. Singapore. McGraw-Hill 2. Madura, J., 2007. International Financial Management. New York. 3. Daves, P. Brigham, E., 2005. Intermediate Financial Management. McGraw-Hill. 4. ‘National Economic Accounts". United States ( http://www.bea.gov/national/index.htm.) 5. Frankel, J., 2007. ‘What's Ahead: Decade of the Dollar, the Euro, or the RMB?’ 6. Country Finance Main Report: April 26, 2006. (http://portal.eiu.com/index.asp?layout=displayIssueArticle&issue_id=180437203&article_id=290437214) 7. Triennial Central Bank Survey., 2007. Bank for International Settlements. 8. China View, 2009. Britain's CPI index drops to five-year low in September. 9. XE. Currency Calculator (http://www.xe.com/ucc/convert.cgi?Amount=1&From=GBP&To=USD&image.x=65&image.y=20&image=Submit) 10. WARDELL, J., 2010. ‘Britain sells off public assets to boost finances’. 11. OZforex. Option pricing calculators Retrieved 2010-06-10 (http://www.ozforex.com.au/cgi-bin/currency-option-pricing-tool.asp) Exhibits             Forward Market Hedge                       Spot Rate 1.45571         Forward Rate 1.4663                                 2500 GBP x 1.45571 = 36392.75   25000GBP x 1.4663 = 36657.5               Profit From Strategy 36657.5 - 36392.75 264.75               Money Market Hedge                       Borrowed Sum 25000 GBP                     Converted to USD 25000 x 1.45571 = 36392.75             Invested 3 month USA 36392.75 x 1.0012 = 36436.42                         Interest on Borrowed in UK 25000 x 1.0027 = 25067.5             Options Hedge                       Strike Price 1.5                     Option Premium 441                     If option Exercised                       25000 GPB short 25000 x 1.5 = 37500             If option not Exercised           Sunk cost 441                     Read More